The Effects of the 2003 Dividend Tax Cut on Corporate Behavior: Interpreting the Evidence

The 2003 dividend tax reform has generated renewed interest in understanding the economic effects of dividend taxation. The reform introduced favored tax treatment of individual dividend income, whereby dividends are taxed at a rate of 15 percent instead of facing the regular progressive individual income tax schedule with a top rate of 35 percent. Several recent studies have used the 2003 tax cut as a “natural experiment” to learn about the effects of dividend taxation on corporate behavior. These studies have obtained divergent empirical results despite using the same underlying data. The goal of this paper is to re-examine the evidence using newly available data and reconcile some of the contradictory results in this recent literature. We focus on three questions: (1) Did the tax cut cause the surge in dividends or were other factors responsible? (2) Did the tax cut induce substitution of repurchases for dividends, or did total payout rise? (3) Did the tax cut induce more efficient distribution of investment funds across firms?